Do I have to pay taxes on the total amount of the settlement? No, only the part of the liquidation that is not related to physical injury or illness is taxable. This includes payments made for emotional distress, lost wages, and punitive damages. For sued companies, legal agreements are almost always tax deductible, as are legal fees. In fact, with the exception of legal fees that must be capitalized to obtain an asset, such as buying one company from another or buying real estate, legal fees are almost universally deductible by companies.
You can even deduct legal fees related to conduct that is clearly not tax-deductible (such as a company negotiating with the government to pay a criminal fine). The criminal fine may not be deductible, but legal fees are. Even punitive damages are tax-deductible for businesses, no matter how bad the conduct is. Over the past few decades, Congress has introduced several proposals to eliminate the tax deduction for punitive damages, but none have been approved.
Since survivors are empowered to file lawsuits, it makes sense to wonder what the settlement will look like, especially when it comes to taxes. While personal injury lawsuits are not taxable, it can be difficult, if not impossible, to prove that a physical injury occurred in a sexual abuse situation that occurred years ago. Under the tax code, damages for personal physical injury or physical illness are tax-free. Damages from emotional injuries are not. However, if you have emotional injuries caused by physical injuries, damages from emotional injuries are also tax-free.
What constitutes a personal physical injury or illness isn't defined, but the IRS likes to see “observable bodily harm,” such as bruises or bone fractures. However, if you are sexually assaulted or abused, you may not have these signs. Interactions between physical and emotional injuries and illnesses are beginning to be explored. Some plaintiffs in labor lawsuits have obtained settlements classified as tax-free.
In one case, stress at work resulted in a heart attack. In another case, stressful conditions aggravated the worker's pre-existing multiple sclerosis, which was clearly a tax-free recovery from physical illness. Damages caused by post-traumatic stress disorder may also qualify. Minimizing taxes is important, because if you have to pay taxes, there's a double whammy.
Because of tax deduction rules, if a recovery is taxable, you may not be able to deduct all legal fees. Montemurro, the IRS assumes that there were personal physical injuries when the abuse occurred, even though the lawsuit and settlement were initiated many years later, when there would probably be no more observable bodily harm. Ellingstad said that this provision, which prohibits the characterization of pay as a wage, could cause some confusion for employers. Susan Ellingstad, a partner at Lockridge Grindal Nauen and director of the firm's employment law department, said the exception is limited and rarely applies to cases of sexual harassment. Survivors with outstanding liquidations may not have to pay for this ruling on the taxation of their liquidations.
The problem of compensation for damages for sexual harassment and abuse is the tax treatment of these liquidations. An assignment could reduce tax exposure for both parties, so it may make sense to get tax advice. Sexual abuse and legal agreements to provide a limited form of redress are common, and yet the way in which those recoveries are taxed remains unclear. On average, there are 463,634 victims (age 12 and older) of rape and sexual assault each year in the United States. However, be careful, tax legislation in this area is still under development and contested tax cases are likely to arise in the future where defendants cancel all or a large part of their agreements for sexual harassment and legal fees and then try to defend themselves.
Most of the agreements were finalized so that most of the payments were considered taxable income for federal and state income tax purposes. Supporters of the change say that these agreements should be treated the same way as the financial compensation a person can receive for being physically injured on the job, which is exempt from state and federal taxes. A plaintiff who has settled for sexual harassment or abuse has nothing to lose if they seek the return of some or all of the taxes withheld from settlement payments, even if the refund is made more than three years after payment of the settlement. This blog offers the possibility for plaintiffs to consider requesting a tax refund and receiving a refund of taxes that were previously withheld from the settlement.
Some plaintiffs claim that the bullying caused them to have post-traumatic stress disorder, and it could be said that PTSD is physical for tax purposes.
